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Chapter 7 Internal Controls Internal controls consist of all the related methods and measures adopted within a business to: Safeguard its assets from employee theft, robbery and unauthorized use; and Enhance the accuracy and reliability of its accounting records by reducing the risk of errors (unintentional mistakes) and irregularities (intentional mistakes and misrepresentations) in the accounting process Internal controls are both preventive and detective. Preventive controls are designed to keep thefts from occurring. Detective controls are designed to detect thefts once they happen. Key internal control principles include: Establishment of Responsibility If possible, you want one person to be responsible for one task. That way if something goes wrong, then you know who is responsible and who to blame. Segregation of Duties Don’t let one person do everything. You want different people assigned to related tasks. If one person does everything, then it is easy to steal, and there is no one to spot another’s mistakes. For example, one person should order goods; another should sign for the receipt of goods; and a third should pay for the goods. If one person did everything, he or she could arrange for the company to pay for inventory that was never received. Another example would be that one person should make a sale, another should ship the goods, and a third should bill the customer. If one person did everything, he or she could fail to fully bill customers for shipped goods (for kickbacks or for sales to friends). Another example would be to separate the job of receiving payments from customers from the job of accounting for the receipts. If one person receives and records payments from customers, he or she could pocket the receipts while reporting the bills paid to the customers and reporting to the company that payments are not yet received. Another example would be to separate the job of making sales from the job of authorizing credit. If one person does both jobs, he or she might extend credit to inappropriate persons in order to increase his or her sales commissions. Documentation Procedures Procedures should be established requiring the use of documents. Moreover, all documents should be prenumbered and accounted for. This helps to prevent undocumented transactions from failing to be recorded. It also helps to prevent documents from being lost. Physical, Mechanical and Electronic Controls Physical controls help to safeguard assets. For example, using safes and locked cash boxes helps to prevent cash from being taken by employees. Use of locked warehouses, burglar alarms, security cameras helps to prevent inventory from being taken. Use of passwords on computers helps to prevent unauthorized tampering with company assets and records. Use of time clocks helps to prevent employees from coming late and leaving early. Independent Internal Verification The company checks to see whether there are any discrepancies in the records of its employees. This is done regularly or on a surprise basis. It is done by an employee independent of the person being checked. Any discrepancies are reported to the management of the company. Rotating Employees Duties & Requiring Vacations The company should insist that every employee take a vacation. When someone else does an employee job it is easier to spot discrepancies. If an employee is stealing, they will never take a vacation for fear that a discrepancy will be spotted. For the same reason, a company should not let the same person stay in one job for long periods. Bonding of Employees Who Handle Cash Bonding companies insure a company against losses from theft by employees who handle cash. The insurance company screens an employee before insuring them. In addition, if any loss occurs, and insurance company will vigorously prosecute all offenders and track them down (like bail jumpers) in order to deter other potentially dishonest employees. Internal Controls Over Cash Disbursements Cash received from sales in a store are handled by issuing cashier's a given amount to be placed in the cash register (the change fund). Afterward, the amount received from the public is compared to the cash register tape. To the extent that any differences exist, the amount is charged to Cash Short and Over. In the case of a shortfall: D. Cash Cash Short & Over Cr. Sales Revenue $980 20 $1,000 In the case of too much cash: D. Cash Cr. Cash Short & Over Sales Revenue $1,000 20 $980 At the end of the accounting period, the Cash Short and Over Account is treated as an expense or miscellaneous revenue account. Cash received in the mail from customers is noted on a remittance advice. If amounts are stolen it will show up with inconsistencies between cash remittances and amounts credited to customers. If the wrong amount is credited to customers, the customers should complain. As noted above, companies should separate those who handle the cash (a cashier's department), and those who record the cash transactions (an accounting department). Checks received in the mail are stamped "For Deposit Only", this prevents someone other than the payee from depositing the check. A voucher system should be used to make payments on liabilities of a company. No check is made until a voucher is prepared by the accounting department and approved by an official of the company. The check is then issued and given to the creditor of the company. Electronic funds transfer (EFT) systems are used to keep the cost of issuing checks down. Petty Cash Fund Sometimes a company has to pay cash for some expenses. To handle these transactions, a company sets up a petty cash fund. The journal entry is: D. Petty Cash Cr. Cash $100 $100 When cash is paid out of this fund, the recipient of the petty cash records how much funds were received and for what purpose on a petty cash receipt form. Later when the petty cash fund is replenished, you treat it as if you paid the expenses recorded on the petty cash receipt forms: D. Office Supplies Store Supplies Miscellaneous Expense Cr. Cash $50 40 10 $100 Bank Accounts When you open an account, you will complete a signature card. This specifies who is allowed to sign checks or withdraw money from the bank account. A transaction register or check register lists every check written on the account. A business check is often accompanied with a remittance form explaining why the check is being paid. For example, it will identify that it is paying an invoice dated on a particular date. Once a month, the bank returns a company's canceled checks with the bank statement. The bank statement shows the bank balance at the beginning of the month, all additions and deductions during the month, and the balance at the end of the month. A bank statement's end-of-month balance rarely agrees with the balance in the company's books for that date. Thus, the accountant must prepare a bank reconciliation to account for this difference and to locate any errors made by the bank or the company. The bank reconciliation begins with the balance per books and balance per bank statement figures as of the bank statement date. Each figure is adjusted by certain additions and deductions, thereby resulting in two adjusted cash balance figures, which should agree. The balance per books figure is adjusted by information that the bank knew at the bank statement date but that the company did not. The balance per bank statement figure is adjusted by information that the company knew at the bank statement date but that the bank did not. Examples of adjustments are as follows: Outstanding checks are a deduction from the balance per bank statement. Deposits in transit are an addition to the balance per bank statement. Service charges by the bank appear on the bank statement and are a deduction from the balance per books. A customer's non-sufficient funds (NSF) check is deducted from the balance per books. Interest earned on a checking account is added to the balance per books. Miscellaneous charges are deducted from the balance per books; miscellaneous credits are added to the balance per books. If the bank is collecting promissory notes on behalf of the company, a collection of a promissory note would be added to the balance per books. After the bank reconciliation has been prepared, adjusting entries must be made so that the accounting records will reflect the new information supplied by the bank statement. Promissory Note collected by bank: D. Cash Cr. Note Receivable $100 $100 Check returned from bank "Not Sufficient Funds": D. Accounts Receivable Cr. Cash $100 $100 Service Charge for month: D. Bank Service Charge Expense Cr. Cash $100 $100 Interest accrued on bank account: D. Cash Cr. Interest Income $100 $100 Recorded amount of check received lower than actual amount (Book Error – Need to reduce Cash and Account Payable by more): D. Cash Cr. Accounts Payable $100 $100 Nature of Cash Cash and cash equivalents include coin, currency, checks, money orders, and money on deposit with banks and similar financial institutions. The money on deposit is supposed to be available for unrestricted withdrawal. Deposits that are restricted for under 90 days is considered cash. Companies frequently have excess cash on hand for short periods of time. These may be invested in cash equivalents. Cash equivalents are short-term, highly liquid investments that are both: Readily convertible to known amounts of cash; and So near their maturity that their market value is relatively insensitive to changes in interest rates. Examples of cash equivalents are Treasury bills, commercial paper (short-term corporate notes), and money market funds. Cash and cash equivalents do not include cash that is not available for general use, but rather is restricted for a special purpose. For example, landfill companies are often required to maintain a fund of restricted cash to ensure that they will have adequate resources to cover closing and clean-up costs at the end of a landfill site’s useful life. Restricted cash is reported on a balance sheet as “Restricted Cash” not part of “Cash and Cash Equivalents”. Managing and Monitoring Cash A business needs to have enough cash on hand to meet its cash needs on time (e.g., make payments when required). It is better if the cash needs are met from the company’s operations (no cost) rather than borrowing (interest cost). Company treasurers or chief financial officers need to manage their cash receipts and payments effectively. The following are basic principles of cash management: Increase the speed of collection on receivables (e.g., offer sales discounts). Inventory ties up resources. Keep inventory levels low (e.g., just in time inventory practices). Delay payment of liabilities, but don’t pass up purchase discounts. Plan timing of major expenditures so that you still have adequate cash to meet current needs. Invest idle cash to earn interest. Cash Budgeting A company should estimate its future cash receipts and needs in order to help it manage its cash effectively. This is accomplished through a cash budget. A cash budget usually covers a one-year or two-year period. It shows cash inflows, cash outflows, and cash from financing when a shortfall is anticipated: Cash Budget Beginning Balance of Cash Add: Cash Receipts (itemized) Collections from customers $168,000 Sale of Securities 2,000 Total Cash Receipts Total Available Cash Less: Cash Disbursements Materials $23,200 Salaries 62,000 Cash Selling & Adm. Expenses 94,300 Truck Purchase 30,000 Income Tax Expense 3,000 Total Cash Disbursements Cash Deficiency Add: Financing Borrowings Ending Cash Balance $38,000 170,000 $208,000 -212,500 -$4,500 10,000 $5,500 Financial Statement Analysis Financial analysts study how effectively a company manages its cash flow using two ratios: Ratio of Cash to Daily Cash Expense This ratio gives the number of days that the company can operate without an additional infusion of cash: Cash and Cash Equivalents ------------------------------------------------Average Daily Cash Expenses Free Cash Flow Free Cash Flow provides an assessment of a company’s liquidity and financial flexibility: – – Cash Provided by Operations Capital Expenditures Cash Dividends Free Cash Flow